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SINGAPORE, March 7 (Complinet) - In an emerging market such as China, where its codes of market conduct oftentimes fail to keep up with market developments, shareholders and investors dabbling in its equities market remain largely unprotected. Even then, the lack of protection has far from become a deterrent to them. The reason, according to Zhengjun Zhang, senior research fellow at the Development Research Center of the State Council of China, was due mainly to the rush for returns from the country’s burgeoning albeit nascent equities market, which has continued to see rapid growth in new firms seeking an initial public offering.

A study of China’s corporate governance models adopted by Chinese listed firms and company law-governed non-listed firms reveals a number of features unique to the country whose history in corporate governance dates back to the early 1990s and follows closely that of Japan’s model.

The most striking feature of China’s corporate governance model, and perhaps a fundamental flaw, is a shareholding structure dominated by controlling shareholders, Zhang, whose center advises the government on economic matters, told Complinet in an interview.

Such a governance structure is further burdened by dual bodies made up of the board of directors and the supervisory board, with the latter having the power to supervise the activities undertaken by the board. The members of the supervisory board are nominated internally and often made up of senior management of the company, he said. Despite the potential conflict of interest that could result from such a structure and recent debates over the role of the supervisory board, Zhang said the supervisory board continues to feature in many listed firms.

FUNDAMENTAL FLAW

But it is the very feature of having the controlling stake concentrated in the hands of a few individuals that very often sees minority shareholders’ rights being compromised. This, according to Zhang, is due to controlling shareholders’ deep involvement in decision-making, which, although it allows quick decisions to be made, also presents the greatest challenge where related-party transactions are involved. He cited an example where it was commonplace to see controlling shareholders of listed companies shift their assets into another firm they controlled in what he called “non-transparent and inequitable transactions.” As a result, minority shareholders sometimes ended up acquiring bad assets at high prices or investing in a company that was running at a loss, he said.

Another problem with shareholding concentrated in the hands of a few majority shareholders was that it deterred hostile takeovers, which Zhang said was not necessarily a good thing for Chinese listed firms. “Mergers and acquisitions are very useful for any company; it puts pressure on the board of directors and senior managers in running the firm and ensures that they pay back shareholders’ investment,” he said.

The problems China now faces pertaining to the “concentrated and controlling shareholding structure” are, in Zhang’s view, a universal phenomenon common to many countries in the early stages of market development.

He said the inherent flaw of the concentrated and controlling shareholding structure lies chiefly in the fact that corporate governance remains a relatively new concept in China and has not evolved much after the China Securities Regulatory Commission officially introduced it as a regulation in 2002. “When the concept of corporate governance from OECD was introduced into China in the late 1990s, Chinese regulators, legislators and researchers had considered not just the corporate governance structure but also its content, transparency and disclosure issues, as well as market pressure. We are gradually improving and are moving closer to the developed markets’ models,” he told Complinet.

A more intractable issue emerges when state-owned enterprises, commonly known as SOEs, are the controlling shareholders — a situation that Zhang said was further exacerbated by the Chinese government’s fear of losing state assets. Recent criticism of China’s SOEs having made great losses on state assets also partly explained their insistence on holding tightly to the rein of a majority shareholding in listed firms, he said. To date there are 2,100 listed companies (both state-owned and privately held) in mainland China, and half of those listed firms’ controlling shareholders are SOEs, according to Zhang.

WEAK ENFORCEMENT

The future challenges of Chinese regulators in enforcing corporate governance lay in how effective they were in executing the provisions of Chinese laws, he said. For instance, although the protection of minority shareholders has been written into China’s company laws, Zhang said the crux of the issue still lay in how the provisions of those laws were enforced. To this end, he saw improving the efficiency of the court system, particularly in respect of expanding its capacity in handling a large number of litigation cases, as the most crucial step in backing up enforcement actions.

With local governments predominately driven by economic performance, protecting shareholders’ rights can sometimes take a backseat. To this end, Zhang cited the independence of local governments as the single most important factor that would allow reforms to the country’s legal infrastructure. He also suggested fighting against the violation of minority shareholders’ rights with issues such as abusive related-party transactions, misleading and untimely information disclosure, and insider trading as being the most imperative.

Zhang was also candid about the inherent weaknesses in the Chinese judicial system, which he said has not been helped by laws that are either outdated or “loose” in standards. China’s company law, for instance, underwent its first revision only in 2005 after a good 12 years following its official promulgation. “All this and a culture that favours seeking harmony over pursuing cases in court explain why it is difficult for minority shareholders to raise litigation issues and seek legal redress,” he said.

Zhang, however, remained upbeat and saw room for improvement. “China has come a long way, having studied the corporate governance models of the US, the UK and even Hong Kong. It is important to note that Chinese legislation differs from the Anglo-Saxon system. China still needs to improve its regulations and could learn lessons from the developed countries. Their regulations can be a good benchmark for China’s securities regulator.”

(This article first appeared in Complinet (www.complinet.com). Complinet, part of ThomsonReuters, is a leading provider of connected risk and compliance information and on-line solutions to the global financial services community.)

(This article first appeared in Complinet (www.complinet.com). Complinet, part of ThomsonReuters, is a leading provider of connected risk and compliance information and on-line solutions to the global financial services community.)